Bear Stearns bailed out by Fed, J.P. Morgan

AlistairBarr

SAN FRANCISCO (MarketWatch) -- Bear Stearns Cos. Inc. went on life support Friday, forced to accept an extraordinary bailout package after being deserted by the clients and counterparties at the heart of the 85 year-old Wall Street firm's business.

Triggering a sell-off throughout the financial sector, Bear shares slumped 47% to $30, their biggest one-day drop in at least two decades.

Bear
BSC, -3.18%
said the rescue consists of getting short-term financing from the Fed, through J.P. Morgan, after its liquidity "deteriorated significantly" during the past 24 hours.

Bear said the financial support is a bridge to a more permanent solution. Several analysts predicted the firm will likely be acquired quickly by a stronger bank or broker to stop its troubles triggering broader problems in the financial system.

"The financial system supervisors are attempting to prevent this company's problems and the perception of problems from rippling through the system to other financial players," David Hendler, an analyst at CreditSights, wrote in a note to investors. "Given Bear Stearns' huge impact in the mortgage, derivatives and funding markets, we sense that a salvation acquisition is the most likely possibility."

Cracking

Bear's crisis is the latest sign that the U.S. financial system is cracking under the weight of a global credit crunch that was sparked by last year's subprime mortgage meltdown. The Fed has slashed interest rates and central banks have injected roughly $1 trillion into the banking system since then, but the crunch continues.

The Fed's decision to bail out a brokerage firm recalls other financial crises in which authorities tried to limit turmoil by propping up institutions including Penn Central, Continental Illinois, Orange County, California and hedge fund Long-Term Capital Management.

"What is different this time is that the dominoes are falling in so many different sectors, markets, industries and countries -- all at the same time and there is yet no end in sight," said Sherry Cooper, chief economist at BMO Capital Markets.

Bear's situation turned dire this week by growing concerns that it's struggling to trade with some counterparties. Some market participants have been worried about Bear's exposure to the dwindling mortgage business and its holdings of securities backed by home loans.

Trading is the lifeblood of brokerage firms, so when counterparties pull back trouble often ensues.

Liquidity

"Our liquidity position in the last 24 hours had significantly deteriorated," Alan Schwartz, chief executive at Bear, said in a statement. "We took this important step to restore confidence in us in the marketplace, strengthen our liquidity and allow us to continue normal operations."

In announcing the dramatic plan, J.P. Morgan
JPM, -1.56%
said it's providing Bear
BSC, -3.18%
with secured funding for up to 28 days, in conjunction with the Federal Reserve Bank of New York.

The New York Fed said its board unanimously backed the plan. "The Federal Reserve is monitoring market developments closely and will continue to provide liquidity as necessary to promote the orderly functioning of the financial system."

J.P. Morgan also said it's working with Bear to secure permanent financing or "other alternatives" for the brokerage firm.

"Bear needs to raise $3-to-$5 billion of equity within the next couple of days to address concerns; it needs support or firms will withdraw from doing business with Bear," Egan Jones analysts wrote in a Friday research report. "Bear shares are down again today, this time because of concerns about viability [banks are insisting on higher margin levels]," they concluded.

Junk warning

Standard & Poor's and Fitch Ratings slashed their ratings on Bear to BBB, one level above junk status, and warned that more downgrades could follow. Moody's Investors Service cut to Baa1, which is also close to junk levels, and warned of another possible downgrade.

Bear built a business focused on originating mortgages and repackaging them into mortgage-backed securities and collateralized debt obligations, reaping profits from the full spectrum of the real-estate financing process.

But when the subprime-fueled mortgage crisis took hold last year, "Bear did not get out of the way fast enough," as Dick Bove, an analyst at Punk Ziegel & Co., put it in a research note to clients earlier this week.

"Consequently, its balance sheet, its business operations, and its reputation were all hurt badly. One key result of this is that the firm's borrowing costs rose sharply according to reports," Bove wrote.

He added that because the broadening credit crunch has undermined Bear's business model, the firm may end up being acquired.

Achilles heel

Schwartz said late Monday that Bear wasn't facing liquidity problems and the firm was able to meet requests for cash from clients and counterparties. But that changed quickly as the week progressed and the market became more concerned about the firm.

By Thursday, Bear was facing a rash of cash calls from hedge fund clients, counterparties in the important "repo" financing market and similar demands on derivatives trades.

Then counterparties which Bear relied on to provide financing on its collateral pulled that support, triggering the firm's liquidity crisis and pushing it into the arms of the Fed.

"Even though the company's stated liquidity was robust, the lack of counterparty willingness to trade was its Achilles heel," CreditSight's Hendler said.

J.P. Morgan is Bear's clearing agent for its collateral, so the bank already knew what type of assets the brokerage firm held to back its loans. That made it easier for J.P. Morgan to step in quickly and help Bear access the Fed's emergency funding.

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